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Ch 5 Slide Show - Chapter5 Bonds,BondValuation,and...

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1 Chapter 5 Bonds, Bond Valuation, and  Interest Rates
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2 Topics in Chapter Key features of bonds Bond valuation Measuring yield Assessing risk
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3 Value =                         +                         +     + FCF 1 FCF 2 FCF (1 + WACC) 1 (1 + WACC) (1 + WACC) 2 Free cash flow (FCF) Market interest rates Firm’s business risk Market risk aversion Firm’s debt/equity mix Cost of debt Cost of equity Weighted average cost of capital (WACC) Net operating profit after taxes Required investments in operating capital = Determinants of Intrinsic Value: The Cost of Debt ...
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4 Key Features of a Bond Par value:  Face amount; paid at  maturity. Assume $1,000. Coupon interest rate:  Stated interest  rate.  Multiply by par value to get dollars  of interest. Generally fixed. (More…)
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5 Maturity:  Years until bond must be  repaid.  Declines. Issue date:  Date when bond was  issued. Default risk:  Risk that issuer will not  make interest or principal payments.
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6 Call Provision Issuer can refund if rates decline.  That  helps the issuer but hurts the investor. Therefore, borrowers are willing to pay  more, and lenders require more, on  callable bonds. Most bonds have a deferred call and a  declining call premium.
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7 What’s a sinking fund? Provision to pay off a loan over its life  rather than all at maturity. Similar to amortization on a term loan. Reduces risk to investor, shortens  average maturity. But not good for investors if rates  decline after issuance.
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8 Sinking funds are generally  handled in 2 ways Call x% at par per year for sinking  fund purposes. Call if r d  is below the coupon rate and bond  sells at a premium. Buy bonds on open market. Use open market purchase if r d  is above  coupon rate and bond sells at a discount.
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9 Value of a 10-year, 10%  coupon bond if r d  = 10% V B = $100 $1,000  . . .  + $100 100 100 0 1 2 10 10% 100 + 1,000 V = ? ... =  $90.91 +    . . .   + $38.55   + $385.54 =  $1,000. + + (1 + r d ) 1 (1 + r d ) N (1 + r d ) N
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10 10 10 100 1000 N I/YR PV PMT FV -1,000 $   614.46       385.54     $1,000.00 PV annuity             PV maturity value  Value of bond = = = INPUTS OUTPUT The bond consists of a 10-year, 10%  annuity of $100/year plus a $1,000 lump  sum at t = 10:
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11 When r d  rises, above  the coupon rate, the  bond’s value falls below  par, so it sells at  a discount. 10 13 100 1000 N I/YR PV PMT FV -837.21 INPUTS OUTPUT What would happen if expected inflation  rose by 3%, causing r = 13%?
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12 What would happen if inflation  fell, and r d  declined to 7%?
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